Arch Coal emerged from bankruptcy on October 5, 2016 and recently filed its 2016 10-K which included its fourth quarter performance (Oct. 2 to Dec. 31) as a reorganized (i.e. successor) company. With its quick emergence from Chapter 11, substantial reduction in debt and strong liquidity position, the company is upbeat about its ability to both weather any further market weakness and seize upon future opportunities.
Arch reported a fourth quarter profit of $33.4 million or $1.31 per diluted share. Given the elimination of $4.8 billion of debt and fresh start accounting adjustments that, for example, reduced the carrying value of its property, plant and equipment by nearly 80% and depreciation/amortization expense by more than 50%, its performance is not directly comparable to the 2015 fourth quarter. Nevertheless, it is possible to look at some metrics to get a perspective on its fourth quarter performance.
The company reported 2016 fourth quarter sales of $575.7 million on 26.8 million tons of sales volume. By comparison, it reported 2015 fourth quarter sales of $563.2 million on 29.2 million tons. Although the comparison may not be truly apples-to-apples, it is clear that 2016 fourth quarter sales were up slightly, while unit volume was down by about 8%. Average prices increased by more than 10%.
Within its operating segments, sales and unit volume were down in the Powder River Basin, but sales increased slightly in Appalachia, as a 17% increase in the average sales price per ton offset a 13% decline in unit volume. The increase in Appalachia’s average sales price was due mostly to a late 2016 surge in global metallurgical coal prices.
Quarterly comparisons of cash flows metrics (including EBITDA) also provide some insight into the company’s performance. By my calculations, Arch recorded EBITDA of $79.5 million in the 2016 fourth quarter compared with ‑$23.9 million in 2015. (My definition of EBITDA differs from the company’s definition of adjusted EBITDAR in several important ways.) Besides the apparent year-over-year accounting differences, there was a lot of noise in both periods, especially in the 2015 fourth quarter which preceded the company’s January 2016 bankruptcy filing.
Similarly, I calculate Arch’s 2016 fourth quarter cash flow from operating activities at $84.2 million, up from $32.3 million in 2015. While positive cash flow seems to be a recurring pattern for the fourth quarter, Arch’s CFOA was noticeably higher in 2016. That also helps to confirm the company’s better overall financial performance.
The improvement in Arch’s performance is encouraging, but how much more should we expect in 2017 and how might that affect the company’s valuation?
In its fourth quarter press release, Arch provided guidance on a range of key financial and operating metrics for 2017. Sales volume is projected to be between 95.2 and 103.8 million tons in 2017, up 1.4% to 10.5% from an estimated 93.9 million tons in 2016.
It is difficult to pinpoint exactly how the anticipated change in unit volume will affect Arch’s three business segments. Management provided volume guidance by coal type – i.e. for coking, PCI (Pulverized Coal injection) and thermal coals; but Arch’s Metallurgical segment also produces a modest amount of thermal coal. How thermal coal is allocated across the segments can influence both segment results and consolidated sales and profits.
I have assumed that Arch’s Appalachian segment will sell 3.6 million tons of thermal coal in 2017 and its Other Thermal segment will sell 7.0 million tons of thermal coal. With those assumptions, management’s guidance implies that Arch’s Powder River Basin segment will sell 81 million tons of coal in 2017, up 6.2% from 2016, and its Appalachian segment will sell a total of 11.0 million tons of coal, up 0.4%. My 2017 sales volume projections for the PRB and Appalachian region are roughly consistent with the EIA’s regional production estimates.
My assumptions also assume a modest decline in the average sales price per ton in the Powder River Basin and a sharp increase in the average sales price in the Appalachian region. My assumed drop in PRB pricing is consistent with recent trends. On the Q4 conference call, management noted that electric power producers still have excess coal inventories (even though they did work off a considerable part of their stockpiles in 2016). Arch expects that this drawing down of stockpiles will continue until customer inventories reach normal levels soon after mid-year. Once that happens, the downward pressure on PRB pricing should subside.
Pricing in Appalachia has been driven by the sharp run-up in seaborne metallurgical coal prices in 2016. Over the past few months, met coal prices have started to come down. Spot prices, which had been running well above the Australian met coal benchmark in the third and fourth quarters of 2016 are now considerably below benchmark; but they are still well above the average spot price over the past three years. Although the global economic recovery is picking up steam, some of the unique circumstances which caused met coal prices to spike in the second half of 2016 are no longer present. Consequently, met coal prices will likely hold (or perhaps even trend slightly downward) for the balance of 2017.
Although seaborne met coal prices are well above domestic prices, Arch has said that it is committed to serving its U.S. customers. Consequently, it will forego some of the opportunity to capture higher prices through exports in order to meet its domestic requirements. Even so, the company announced on March 7 that it had expanded its ownership interest in Dominion Terminal Associates (DTA) from 22% to 35% with the purchase of the stake previously held by Peabody Energy. The purchase increases its annual throughput capacity from 4.8 million tons to 7.7 million tons. This gives the company the ability to ship more of its own coal overseas (or alternatively, the ability to earn profits on the added export volume of coal produced by other companies).
With all of these assumptions, I currently project that Arch will generate revenues of $2.24 billion, net income of $129.5 million and diluted EPS of $5.77 per share in 2017. My EPS projection is considerably below the current consensus estimate of $9.11 per share. To the extent that the consensus estimate is also consistent with management’s guidance, the difference between my EPS estimate and consensus is most likely due to differences in the split in sales volume between the PRB and Appalachia and also in the average sales price per ton assumptions. My EPS projection does include an $11.5 million or $0.52 benefit from a 500 basis points reduction in the interest rate on the company’s new credit facility; but it does not include any anticipated benefit from Arch’s increased stake in DTA.
Should industry sales volumes continue to increase in 2018 and beyond, Arch may have some difficulty in maintaining its market share, especially in met coal. Management has done a remarkable job of scaling down its operations to restore profitability at sharply lower sales volumes. However, it has closed 20 or so mines over the past few years, mostly in the Appalachian region. Those that are left are among the industry’s most efficient producers, but I believe that these mines are operating at or near capacity. Consequently, in order to ramp up met coal production, Arch may have to re-open some of the recently shuttered mines. Such re-starts may be costly and they would also raise the company’s fixed operating costs; so any decision to reopen would not be easy. Arch faces some of the same issues in the Powder River Basin; but since it continues to produce coal there, ramping up of operations would probably be less consequential.
At the current share price of $64.90, Arch’s stock is trading at 11.2 times my projected 2017 earnings of $5.77, which is a meaningful discount to the broader market. Given the current pricing dynamics for both metallurgical coal and PRB thermal coal, I expect that earnings will be strong in the first half of the year, but the company’s ability to achieve full year targets will depend mostly on what happens in the second half of the year. If met coal prices remain strong and PRB prices begin to rise in the second half, I will have to raise my 2017 earnings estimate.
The above valuation does not adjust for the company’s excess liquidity. At December 31, Arch had $464 million of cash, cash equivalents, short-term investments and restricted cash. By comparison, its total outstanding debt was $325 million. If I assume that the cash is used to pay off all of the debt (and the remaining cash kept to meet operating requirements, contingencies and letters of credit obligations under its receivables securitization program), Arch’s projected 2017 interest expense of $26 million would be eliminated. That would raise EPS by an estimated $0.87 per share. Thus, on a net debt basis, Arch’s projected 2017 earnings would be $6.64 and its forward P/E multiple would be 9.7.
Although 2017 is shaping up to be a year of solid performance, Arch’s longer-term outlook depends mostly on the price of natural gas. The current low price gives natural gas-fired power plants a competitive advantage over most coal-fired plants. The current near-term futures contract shows that natural gas has rebounded back above $3 per million BTU’s, after bottoming out at about $2.60 in mid-February. Natural gas prices will probably have to push toward $4 before there is any appreciable switching of power production by utilities to coal-fired units. Although there is still a considerable inventory overhang and significant potential supply of natural gas, the continuing construction of gas-fired power plants, both here and abroad, as well as the opening of export markets as a result of the construction of new LNG terminals will cause demand for natural gas to rise steadily. That excess supply will eventually be worked off.
Chart courtesy of StockCharts.com
Coal stocks have underperformed the market so far this year, due mostly to the disappointment over the trend in natural gas prices and also to expectations that some previously bankrupt coal producers, including Peabody Energy, will soon tap the financial markets for new capital. Although the chart shows Arch’s stock price in a clear downtrend, the price action over the past two weeks may be a preliminary sign that it is stabilizing.
With expectations of solid first quarter results for many coal producers, there is a good chance, I believe, that Arch and the other coal stocks will rebound in the next few weeks. After that, their performance will depend upon the price trend in natural gas, weather conditions and global demand for met coal.
In the meantime, with its strong cash position and low debt, Arch has significantly reduced its financial risk. Arch’s current low share price combined with its strong earnings growth potential should also limit future downside share price risk. On a pro forma basis (i.e. before bankruptcy costs but after capital expenditures and with the current lower annual interest expense), I estimate that Arch burned only $8 million of cash last year. My projections indicate that the company can generate over $100 million in cash flow from operations after capital expenditures and other investing activities in 2017. If so, that extra cash could be used to expand the business, reduce debt, buy back shares or pay a dividend.
It is hard to conceive that operating conditions could get much worse than what we saw in 2016. If they do deteriorate modestly from here, Arch has $300 million or more in cash to cover any shortfalls. With the company’s limited downside risk and significant financial flexibility, Arch’s shareholders can afford to wait patiently for a more meaningful turnaround in the business.
March 23, 2017
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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